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Eye on the Economy: Fiscal Policy Needed to Break Downward Spiral
About a month ago, I suggested that the U.S. economy had slipped into a mild recession during the early part of 2008. This judgment was based on readings of the economic tea leaves as well as anticipation of a decision to be made later in the year by the Business Cycle Dating Committee at the National Bureau of Economic Research — the official arbiter of cyclical peaks and troughs in the U.S. economy.
Economic data received during the past month reduce the probability of an official recession “call” in 2008.
First-quarter GDP growth, originally reported at a paltry 0.6% annualized rate with outright contraction in real final sales (excluding business inventory accumulation), is bound to be revised upward when the Commerce Department releases its next estimate around the end of this month.
Furthermore, early distribution of personal income tax rebates under the economic stimulus program that was enacted in February will bolster consumer spending to some degree, possibly keeping GDP growth in the positive range in the second quarter and paving the way for a decent third-quarter performance.
If things evolve this way, the Business Cycle Dating Committee presumably will not declare an official recession in 2008, even through the committee is quick to point out that quarterly GDP patterns do not dominate their decision-making process.
But a ‘Growth Recession’ Definitely Is in the Cards
While official recession may be avoided, there’s no doubt that the U.S. economy is in a seriously weakened condition. In fact, a combination of sub-par GDP growth and systematic erosion of the labor market qualifies as an unhealthy “growth recession,” a condition that has afflicted the economy since late last year.
Economic weakness is clearly evident in the labor market.
Private sector payroll employment started down last December and the cumulative loss through April came to 312,000 jobs. Total payroll employment, including the public sector, started down in January and already is down by 184,000 jobs. The civilian unemployment rate was up to 5.0% in April, from a low of 4.4% in March 2007.
Looking forward, we expect payroll employment to continue downward into the third quarter of this year and to post only sluggish growth through the early part of 2009. We also expect the unemployment rate to gravitate upward over the balance of this year, topping out around 5.7%.
Housing Still Is the Major Economic Depressant
The housing contraction has continued unabated, laying heavy hits on both GDP and the labor market. The housing production component of GDP ― residential fixed investment ― contracted at a 26.7% annual rate in the first quarter and lopped 1.23 percentage points off the GDP growth rate, essentially the same as the dismal performance in the final quarter of 2007.
Employment in residential construction ― builders and specialty trade contractors ― continued to move downward through April, recording a loss of 33,100 jobs for the month and a cumulative loss of 477,900 jobs from the peak in early 2006.
Downward momentum in home sales and housing starts guarantees another heavy hit to GDP from residential fixed investment in the second quarter of this year, and we now expect a substantial drag on growth to persist through the first quarter of 2009. Employment in residential construction inevitably will decline throughout 2008 and during part of 2009.
Commodity Prices Surge But Core Inflation Is Well Behaved
Oil prices have been surging to higher and higher records in both nominal and real terms, food prices also have been rising rapidly and the weakening dollar has been delivering an inflationary impulse via higher import prices. But key measures of core consumer price inflation (excluding direct energy and food prices) have been remarkably well behaved largely because the weakening job market has held down labor costs per unit of U.S. economic output.
The Consumer Price Index for April released by the Labor Department showed year-over-year top-line inflation around 4%, dangerously high by historical standards.
However, the core component was up by only 2.3% on a year-over-year basis and the annualized pace for April came to only 1.3%.
These core inflation rates certainly are good news for the Federal Reserve, falling within the Fed’s apparent “tolerance zone” for this important inflation gauge.
The Fed Has Adopted a Wait-and-See Posture
The Fed enacted quarter-point cuts in both the discount rate and the target federal funds rate at the conclusion of the April 29-30 meeting of the Federal Open Market Committee (FOMC). The funds rate now is 2.0%, down by 325 basis points since last August, and the discount rate is 2.25%, down by 400 basis points over that span of time.
The April 30 FOMC statement said that economic activity remains weak and that labor markets have softened, and it projected that a combination of tight credit conditions and a deepening housing contraction will weigh on economic growth over the next few quarters.
But the statement also contained some heads-up on the inflation front, including reference to a recent rise in some indicators of inflation expectations.
In fact, the statement moved closer to a balanced assessment of risks to the economic outlook, suggesting that the FOMC is anticipating a pause in its rate-cutting campaign.
While a pause may very well be preferred by a large majority of FOMC members at this juncture, future policy decisions will be determined by incoming information on the real economy and inflation. We continue to believe that further evidence of economic weakness, combined with containment of core inflation, will encourage another quarter-point cut at the next FOMC meeting (June 24-25), moving the real funds rate deeper into the negative zone.
Housing Downswing Deepens and Broadens
The national housing contraction that began in the fall of 2005 has been deepening by virtually any measure. Indeed, single-family permit issuance is down by nearly 70% from the peak in September 2005. Furthermore, the geographic scope of the housing contraction has expanded as the national downswing has deepened
All states now show declines in single-family permit issuance since the national peak in 2005, and only a few Metropolitan Statistical Areas show positive growth since that national peak.
The weakest state and metro performances show up in previously overheated markets in the West and Southeast — Florida, California, Arizona, Nevada and Colorado — and in structurally weak parts of the industrial Midwest — Michigan Minnesota, Ohio and Illinois.
Supply-Demand Imbalance Means Downward Price Pressure
The record-breaking contraction in new housing production since 2005 reflects a combination of profoundly weak demand and unprecedented excess supply on the market.
The Census Bureau’s first-quarter report on residential vacancies showed new records for vacant year-round housing units on the market, whether for sale or for rent. The “home owner vacancy rate” also moved up to a new record high ― 2.9% ― in the first quarter, more than a percentage point above the rate that prevailed early in this decade.
The severe supply-demand imbalance is putting strong downward pressure on national average home prices by most measures. The S&P/Case-Shiller home price measures have been falling since mid-2006, and the rates of decline have been accelerating recently.
The relatively broad Composite 20 series is down by 14% from its peak, and the seasonally adjusted annual rate of decline reached 26% in February. Furthermore, all 20 major metros show declines since last fall, symptomatic of the geographic spread of the contraction in single-family housing production.
Further declines in house prices definitely are in the cards, at least on a national average basis. The way things are going, it’s not unreasonable to expect an additional 10% decline in the S&P/ Case-Shiller measures (including the quarterly “national” measure), although it’s fair to say that we’re in uncharted waters on the house price front.
Fiscal Policy Is Needed to Break the Downward Housing Spiral
Falling house prices pose a huge risk to the U.S. economy and to the financial markets. Falling prices decimate the quality of outstanding mortgages — whole loans and securities structures.
This leads to progressive tightening of lending standards in primary mortgage markets, a process recently documented by the Fed’s Senior Loan Officer Opinion Survey for April.
This tightening process further weakens effective home buyer demand while falling mortgage quality feeds the upswing in foreclosures that dumps more supply onto glutted markets — putting more downward pressure on house prices from both directions.
The diabolical “feedback loops” in the housing and housing finance markets make it extremely difficult to craft forecasts of housing market activity for the balance of this year and in 2009. NAHB’s current forecast shows very large declines in new-home sales and housing starts in 2008, with only modest recovery in 2009.
NAHB’s downbeat housing forecast actually is subject to considerable downside risk. The Federal Reserve would like to break up the feedback loops that are dragging housing downward, but the Fed apparently lacks the tools necessary to do the job.
A fiscal policy solution is sorely needed to spur home buying, stem the upswing in foreclosures and cushion the downdraft in house prices. There’s a lot of activity on these fronts, in both the Senate and the House, and the President presumably would be hard-pressed to veto well-structured legislation to help current home owners and to help stem the housing market contraction.
NAHB Chief Economist David Seiders analyzes the economy from the point of view of the housing market every other week in the free e-newsletter, “Eye on the Economy.” The preceding is a reissue of his May 14 edition. To subscribe to “Eye on the Economy,” click here.
 Want to Know the Housing Forecast for the Top 100 Metros?
Find out in HousingEconomic.com’s 2008 to 2009 Metro Forecast (free preview).
Get the metro forecast with in-depth analysis, overviews and downloadable Excel tables.
To learn more, visit www.HousingEconomics.com.
 Free NAHB Kit Gives Builders Back-to-Basics Tips to Navigate the Slowdown
What was once expected to be a relatively mild housing slump following three years of record new home construction and sales has given way to a significant downturn.
To help members navigate the uncharted waters of this slowdown, NAHB has compiled a comprehensive “Back to Basics” online toolkit — the best of the basics, the tried and true and the truly new. To access the toolkit, click here.
To access the “Back to Basics” toolkit, you must be an NAHB member and have a login to www.nahb.org. To create a login, go to www.nahb.org/login or click on the log-in button on the main menu bar.
For assistance, call the NAHB Member Service Center at 800-368-5242.
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